Yields on 10-year Japanese bonds (JGBs) have doubled in a month and spiked dramatically to 1pc on Thursday, triggering a 7.3pc crash in the Nikkei stock index. It was the biggest one-day fall since the tsunami two years ago, comparable with wild moves seen at the height of the Asian crisis in 1998.

<noframes>Interactive chart: Yield on 10-year Japanese government bond</noframes>

The contagion effect set off a retreat from stocks across the world, though Wall Street later pared losses. The iTraxx Crossover or “fear gauge” for corporate bonds jumped 25 points to 392.

The Bank of Japan (BoJ) intervened with $20bn (£13bn) to drive down yields again but the failure to ensure an orderly debt market has started to rattle investors. Banks, pension funds and insurers appear to be dumping JGBs for fear of being caught on the wrong side of a bond rout.

Richard Koo from Nomura, an expert on Japan’s Lost Decade, said the sell-off in recent days has shown that the BoJ may not be able to hold down yields “no matter how many bonds it buys”. This could lead to a “loss of faith in the Japanese government” and the “beginning of the end” for its economy, if handled badly.

The drama in Tokyo came amid fresh signs that China is struggling to manage the hangover from its four-year lending boom, which has pushed credit to 200pc of GDP and spawned a shadow banking system.

The HSBC manufacturing index tipped below the contraction line to 49.6 in May. “There is simply no recovery,” said Yao Wei from Societe Generale.

China’s leaders are walking a fine line, reluctant to overdo stimulus for fear that it will leak into the property bubble and perpetuate a deformed structure. Fitch says the economic return on lending has collapsed over the past four years from a ratio of 0.8 to 0.35, a sign of credit exhaustion.

Morgan Stanley has stopped relying on Chinese growth data to assess growth, using proxies such as Korean exports and Taiwan bonds.

“China is slowing hard. We are concerned that leverage is higher than reported, and banks have a huge maturity mismatch,” said Hans Redeker, the bank’s currency chief.

Global equities have risen 27pc since July, lifted first by the Fed’s “QE3”, then the move by Mario Draghi at the European Central Bank to back-stop Italy and Spain, and, finally, by the reflation blitz of Japan’s premier, Shinzo Abe.

Mr Redeker said this phase is over as the Fed shifts gears, with the latest Fed minutes showing that several rate-setters want to wind down bond purchases as soon as June. Chairman Ben Bernanke has given mixed signals, but it is clear that the Fed’s centre of gravity is shifting.

“The Fed is moving to neutral. That is why stocks are getting hammered. It is toxic for anybody around the world who relies on dollar funding, and that means emerging markets,” said Mr Redeker.

Marc Ostwald of Monument Securities said Ben Bernanke had “signed the death warrant for markets”, while Julia Coronado from BNP Paribas said the Fed’s minutes were “simply astounding”, creating total confusion over when it will taper off QE. “What may be in store over the next few months is a showdown between the markets and the Fed,” she said.

The mere promise of “Abenomics” has lifted Japanese equities by 70pc since November, with foreign hedge funds accounting for a third of all net long positions, but the dark side is becoming clear. The BoJ is purchasing enough bonds to cover 70pc of Japan’s budget deficit this year under the new governor, Haruhiko Kuroda. This is $70bn a month, almost as much as the Fed in an economy one third the size.

Mr Kuroda has played down the spike in yields, though one of his original aims was to cut borrowing costs. “I don’t think the recent rise in yields is having a big impact on the economy,” he said.

Officials cite the rise as proof that investors believe the BoJ will lift Japan out of deflation at long last and achieve the new inflation target of 2pc. Professor Richard Werner from Southampton University, author of Princes of the Yen, said nobody knows whether the bold gambit will succeed.

“They have been very good at marketing, and investors just love Abenomics, but there is a widening gap between the euphoria and delivery. Very little has actually happened to credit creation so far, and without that there will not be a recovery,” he said.

Surging yields have already caused Toyota to shelve a bond issue. The great fear is that a bond rout will set off a banking crisis since Japanese lenders hold JGBs equal to 80pc of GDP. The International Monetary Fund said a 100 point rise in yields would erode the Tier-1 capital of regional banks by 20pc.

“At some point, the JGB market is going to crash. The crucial question is whether they can prevent the banking system from being hurt? It will be tricky, and I am not sure the BoJ has thought this through,” said Prof Werner.

Mr Koo said the BoJ has undermined the “market structure” that has kept Japan’s bond market stable for 20 years, and invited an attack by short sellers.

He said the bank faces a “time inconsistency problem” since markets react more quickly than the economy.

The risk is that inflation fears will lead to bond collapse before the benefits of stimulus have fed through. But Junko Nishikoa from RBS said the fears are overblown. “The bottom line is that Japan’s economy is recovering and the BoJ will succeed in holding down risk premiums,” she said.

Japan has taken a huge gamble, but Mr Abe says the status quo is not an option either. With public debt to reach 245pc of GDP this year, the country must restore growth in nominal GDP to head off a debt compound spiral. That Holy Grail is at last in sight.

The Telegraph Investor

Editor's comment:

Priced to be great value for new investors and those with large portfolios.